How China’s zero-Covid policy is tipping the world into recession

Persistent lockdowns and hardening political rhetoric suggest China’s zero-tolerance approach to Covid-19 will remain over the long term
Collapsing demand, falling middle-class income, supply chain disruptions and a weakening yuan will have consequences that ripple across the globe

Andy Xie

Published: 8:45am, 16 May 2022

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China’s domestic demand is dramatically contracting under the weight of its zero-Covid measures. As lockdowns persist and spread, the extraordinary decline in domestic demand is likely to trigger a global recession.

While reduced Chinese demand for commodities might ease inflationary pressure, the supply chain disruption will more than offset that and keep up the pressure on major central banks to continue raising interest rates into a recession. The world remains on a dual track of real economy inflation and asset deflation.

China’s auto sales fell 48.1 per cent year on year in April, and property sales at China’s top 100 developers were down 58.6 per cent year on year. It is apparent that domestic demand has crashed as Covid-19 lockdowns spread. As more areas get shut down, the May figures could be considerably worse.

With political rhetoric on zero-Covid becoming more rigid, the policy is likely to remain in place for some time. The Omicron variant could easily return, even if case numbers come down to zero, or near zero. Therefore, Beijing has to severely restrict mobility to keep it down over the long term, as some cities in northeast China have experienced for the past six months, and any rebound in domestic demand is a long way off.

China accounts for a big chunk of global growth. It has been the most important driver for multinational companies in holding down production costs and a major source of profit growth from sales to the Chinese middle class. For global companies, the second quarter is likely to be atrocious.

02:30

Shanghai doubles down on quarantine measures in Covid-19 fight

Some of the decline in demand will last beyond the pandemic. The middle class is experiencing a dramatic loss of income. Personal income tax receipts in March fell by 51.3 per cent. The prolonged income collapse will weigh on demand for non-essentials beyond the end of the zero-Covid policy.

China’s April trade data was weak – exports rose 3.9 per cent and imports were flat – but not as weak as domestic demand would suggest. This could be because of orders before lockdowns spread to the eastern seaboard, which is the heart of China’s export-dependent economy.

It will not be so lucky this month as businesses run out of cash to pay for imports. China’s coming import collapse will have a profound impact on commodity producers and luxury traders, and will disproportionately affect emerging economies and Europe.

One could argue that the economic fallout from the zero-Covid policy is temporary as it will change sooner or later. It might, but the proposed system of PCR testing kiosks suggests China may well live with the policy over the long term.

It shifts the burden of virus monitoring to the people, as they will not be able to go to work or buy groceries without a recent negative test. Such a system might keep case numbers low, but not likely at zero. That still means restricted mobility for the population, which will weigh on supply chains and personal income.

China’s big city plan for Covid testing just a 15-minute walk away

The yuan appears to be responding to falling domestic demand. The bond yield gap between the United States and China has shrunk this year and is a driver of currency depreciation, but appreciation pressure was being held down by the accumulation of foreign exchange reserves.

Considering China’s huge annual trade surpluses, its currency should have been well supported despite rising US interest rates. It is likely that the zero-Covid-induced crash in domestic demand and deterioration in trade are driving the depreciation. From that perspective, the yuan’s downward trend will not reverse until the zero-Covid policy changes.

The deteriorating outlook could encourage capital outflows, which will exacerbate pressure on the yuan. China has experienced similar dilemmas before. Even though its capital controls are tight as a drum now, capital will still find ways to leave the country through trade accounts or an onshore asset selldown.

For example, foreign ownership of Chinese bonds and equities still stands at over US$1 trillion. Another source would be paying down more than US$2 trillion of corporate foreign debt, though I doubt the borrowers would have the money to pay.

The crash in domestic demand is difficult to see from outside China because its financial system is government-owned and does not take action during severe credit stress. It can also shore up the domestic equity market to spread the psychological adjustment over time.

Any external effects will show up through trade and the exchange rate. The former is slow, and the central bank can run down forex reserves to stretch out the currency adjustment. Hence, the impact on the global economy will come over time through trade.

The zero-Covid policy will have serious long-term consequences. The massive income loss for the middle class will have a lasting impact on demand. A soft landing for the property market is now almost impossible, and the consequences will severely damage the credit market and middle-class consumption. The collapse in land sales will put numerous local governments in financial distress.

03:22

Beijing’s central business district deserted as government strengthens anti-Covid measures

The pressure on foreign companies to leave China has increased. Some might think their departure would cause the government to think twice, but that is unlikely. Vladimir Putin’s invasion of Ukraine led foreign companies to exit Russia. The Chinese government is probably worried about a similar exodus if a conflict were to break out over Taiwan, so it would be better for foreign firms to leave now and domestic companies to take their place.

If one looks through the prism of an inevitable conflict between China and the US, many things start to make sense. What is happening could be seen as a trial run for managing a wartime society and economy. If businesses and individuals can maintain their loyalty this time, they would be more likely to stick around in the event of a war.

Andy Xie is an independent economist